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Unformatted text preview: Homework 2: Solutions Environmental Economics: ECO 403 Question 1 a. The marginal costs are not equal and so the regulation violates the equi-marginal principle and does not reduce pollution in the least costly way. To reduce costs, pollution needs to be reduced more where it is cheaper to do so (in this case, new cars). For example, if we increase emissions by 1 for old cars, we save $10. If we decrease emissions by 1 for new cars, we pay $5. Overall emissions are unchanged, and thus so are damages. But we have saved $10- $5 = $5. b. Since it is cheaper to reduce pollution in new cars, we want to set up the vintage differentiated regulation so that new cars must pass a stricter emissions test. c. Households will have an incentive to hang on to older cars longer. Since older cars are more polluting, overall pollution may rise even though new cars have a stricter test! Question 2 The gas tax provides an incentive to reduce gas consumption. Therefore, the gas tax provides an incentive for any activity that reduces gas consumption. Further, households will choose whatever method is best for them, lowering the cost of reducing gas. Conversely the CAFE standards require manufacturers to have a specific average fuel econ- omy. In order to increase their average fuel economy, manufacturers must lower the price of fuel efficient cars and raise the price of gas guzzlers. Therefore, CAFE standards indirectly provide an incentive to purchase more fuel efficient new cars, and an incentive not to buy new gas guzzlers. It provides no incentive for other methods to reduce fuel consumption. To the extent that other options are cheaper for at least some people, CAFE standards a more expensive way to reduce gas consumption than the gas tax. Question 3 a. For efficiency, we set demand equal to supply which equals marginal costs, taking care to include the costs of production and the costs to society of production: P = MC + MD, (1) 8- Q = 2 Q + 2 , (2) Q = 2 . (3) 1 b. The monopolist restricts production so as to increase the price. Mathematically, they consider not only that producing one more unit increases revenue by P , but also that the price falls, reducing revenue on all goods sold. The marginal revenue accounts for both effects. In the absence of regulation, firms do not consider the cost to society of polluting, so the monopolist considers only its own costs. Therefore the monopolist sets: MR = MC, (4) 8- 2 Q = 2 Q, (5) Q m = 2 . (6) In a competitive market, the quantity would be found by setting P = MC , which gives Q = 8 / 3. The monopolist restricts production from 8 / 3 to 2 so as to increase the price....
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